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The Circular Flow of Income

The document discusses the circular flow of income model which depicts how money, goods, and services move between economic agents like firms, households, and the government. It also discusses different types of circular flow models including the two-sector and three-sector models and concepts like leakages and injections.

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Rashid okeyo
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34 views

The Circular Flow of Income

The document discusses the circular flow of income model which depicts how money, goods, and services move between economic agents like firms, households, and the government. It also discusses different types of circular flow models including the two-sector and three-sector models and concepts like leakages and injections.

Uploaded by

Rashid okeyo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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The circular flow of income 

is a basic economy model that depicts how


money, goods, and services move between economic agents.
In the basic model, the circular flow of income consists of two
components:

 Firms: companies that produce goods and pay wages to


employees.
 Households: individuals who receive wages from firms while
simultaneously purchasing the goods and services from the firms.

In the real world, the model is a bit more complicated. It has two extra
components: 

 Government: the government receives taxes from firms and


households, then uses tax revenues to pay for public
services. 
 Foreign sector: the foreign sector is responsible for
exporting and importing goods, thus facilitating an exchange
of money between the domestic economy and the rest of the
world. 

In addition to firms, households and governments, there is also


the financial sector that enables money exchange and helps to
convert savings into investments for economic development. 

In the economy, goods and services move in one direction while


money flows in the other way. Goods, money, and
services are the three major flows in the economy. 

Income (Y) = Output (O) = Expenditure (E)


Types of Circular Flow of Income.

Real flow involves two kinds of flows: the flow of factors of


production such as land and labour from individuals to firms, and
the flow of goods and services from firms to individuals.

The real flow depicts how products and services are produced
and consumed in the economy.
Money flow is the transfer of money and other forms of
credit in the economy. It happens when companies pay wages to
workers in exchange for their labour and when individuals use
their wages to pay for goods and services.

In the money flow, income is turned into savings and investment,


then back again. 

Two-sector Circular Flow of Income Model

The two-sector circular flow of income model is a simple picture of


an economy in which the economy is divided into two
components:

individuals
firms. 

Individuals are also called households or the public, while 

firms are businesses or the productive sector. 

The financial sector, government sector, and overseas sector are


excluded in this model. 

The model is based on two assumptions: 


1. Individuals spend all their income on goods and services
without the intention to save part of their income.
2. Consumers purchase all output created by companies
through their consumption. 
Thus, all expenses by individuals are converted into incomes for
businesses. Companies then spend all their earnings on labour, capital,
and raw materials, thereby transferring them back to individuals. This
results in a circular income flow.

Three-sector model

In the three-sector circular flow model, the government is added


to the basic circular flow model (two-sector model). The financial
and overseas sectors are not included. 

The government sector is made up of economic activities by the


municipal, state, and federal governments. 
 
Taxes (T) are the means through which the government
generates income from individuals and businesses. Government
spending (G), including subsidies, transfers, and purchases of
products and services, is how the government redistributes its
revenue to businesses and individuals. 

Every payment has an equal and opposite reception. That is,


each flow of money has an equal and opposite flow of
commodities. As a result, the economy’s aggregate expenditure
equals its aggregate income, which creates a circular flow.
In this model, the national income is in equilibrium when taxes
equal government spending: T=G

Leakages and Injections in the Circular Flow of Income

Leakages are withdrawals from the circular flow. This occurs


when individuals and businesses preserve a portion of their
earnings instead of letting it move to another party. Savings, tax
payments, and imports are examples of leakages that suppress
the flow of money. 
Injections are insertions of income into the circular flow. An
amount of money is injected into the flow when individuals or
businesses borrow. Money for investment, government
expenditure, and exports are examples of injections.
The government sector contributes to leakages by collecting income
from individuals and businesses through taxes (T). This is a leakage
because it lowers the households’ spending on goods and services.
Government expenditure (G), which provides public services and
welfare payments to the community, on the other hand, is the injection
into the circular flow.

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